The Quiet Disaster – Gold Reacts to the Ongoing Debt Crisis

Understanding Gold’s Risk Premium and the Effect of European Debt Problems

By IBT Staff Reporter On 05/24/11 AT 4:30 PM

In November of 2010, I published an article discussing the important correlation between the European debt crises and rising gold prices throughout 2010. Though gold almost always benefits from perceived risk in other markets, we have rarely seen such a clear connection between economic concerns and rising prices. Suffice to say, we learned that debt problems in the Euro Zone have a unique ability to move precious metals markets across the world. Let’s take a look back:

In mid-February, 2010, gold prices hit their low for the year of around $1050 per ounce. The slide which had begun in January was ended abruptly when news came out that Greece was running headlong toward a full scale debt default. On the 18th of March, 2010, Greece asked the EU for a stability loan to maintain solvency. At the time, gold was trading at about $1105 per ounce. By May 10th, the European Union had agreed to assemble a $750 billion bailout fund to help fledgling member states avoid debt defaults. Within 48 hours of this announcement, gold broke $1235 per ounce.

In less than 90 days, the debt crisis in Europe drove gold up more than 17.5%. Don’t forget that the Dow Jones average also lost significant ground (more than 10% at one point) as a result of growing concerns that the debt crisis would not be contained to the far side of the Atlantic. As such, the opportunity cost in holding securities over gold during the last round of EU debt crisis could well have exceeded 25% in 90 days. What did it teach us? When EU debt concerns hit the forefront, gold proved to be the best game in town.

One problem of course was that by the time people really began to understand how crucial the Europe situation really was, the gold price had already started to absorb the risk premium, moving quickly to the upside and erasing some profit potential for the people who didn’t catch the run early. The good news now however, is that this time we should all be prepared.

Just this morning, Bloomberg released news that European Central Governing Council member Christian Noyer called the idea of restructuring Greek debt a “horror show”, saying “There’s no solution possible”. He went on to explain that “The lengthening of maturities raises very difficult questions. There’s a strong chance it will be the equivalent of a default.” On this news, alongside a weaker dollar, gold traded up this morning more than $10 per ounce.

The reality on the ground is that the more than $100 billion given to Greece in the form of bailouts has simply not been enough to stave off catastrophe. With the cost of insuring Greek debt rising almost daily, there is little doubt that we are now right back where we were in March of 2010: staring down the barrel of the cannon that is the European debt debacle. There is however, one major difference.

This year, the political will to fork over more bailout money simply isn’t what it was last summer. More and more grumblings from creditor nations such as Germany have set a more sober tone to the discussion of Greece’s problems. Without more bailouts, the likelihood is high that Greece will default on some portion of its debt. If this happens, it will become nearly impossible to fund the daily operations of the Greek government. As we saw near anarchy and mass demonstrations in Athens resulting from spending cuts, one can only imagine the nightmare that would ensue if basic government services grind to a halt.

The real problem however, is the message that a Greek default would send to investors across the globe. At the moment, the only thing keeping bond money flowing to Greece, Ireland, Portugal and Spain is the hope that the ECB will continue its stance of propping the countries up and avoiding default at any cost. Once one nation goes, it will send a clear message to the rest of the world that the European Union has accepted the debt default of a member state as a viable solution to the crisis. If this happens, Athens may not be the only city in ruins as borrowing costs would make deficits completely unsustainable for other member states.

As you can see, this crisis is far from over. At this point, one of two things must happen. Either there will be more bailout money, or there will be a debt default of some form. Either scenario is extremely bullish for gold, as investors will have to buy it to guard either against inflationary pressures from a bailout, or contagion and catastrophe if there is a default. In the short term, a weaker Euro could provide downward price pressure on gold as the dollar would look stronger in comparison. Over the long run however, there is little doubt that gold would again become the asset of choice in guarding against debt crises.

If gold were to repeat the same pattern we saw last year, we could tack on 17%+ from today’s prices. This would put the metal at over $1780 per ounce. That’s based on the debt crisis that is a few thousand miles away. The real ticking bomb is the staggering debt levels we are carrying right here at home. There is little doubt that a default out of Europe would shake investors’ confidence in all government debt across the globe. Don’t forget that our country is the largest debtor in the world. As several rating agencies have already expressed concerns about America’s ability to meet its obligations, is there a possibility that these same disasters could start to unravel right here at home? Only time will tell. That said, if the US ever comes close to a debt default, I sure wouldn’t want to take bets on how high gold might go.